SunPower (NASDAQ:SPWR) has been banking on its utility-scale solar business to drive growth over the last several quarters, building some of North America’s largest solar power plants including the Solar Star and California Valley Solar Ranch. However, we believe that the company’s residential solar business could also hold a lot of potential going forward. Although the residential space currently accounts for just about 20% of new solar installations in the U.S., it is growing at a much faster rate compared to the broader solar market. The Solar Energy Industries Association (SEIA) estimated that the residential solar market in the United States would grow at an impressive 52% through FY2013 compared to the broader solar market, which is expected to grow at 27%.

The residential market is attractive to solar companies since it provides more stable revenues. This is because it involves selling several small systems throughout the year – unlike the utility scale business, which is driven by large contracts. Residences are also a key target market for high-end solar panels, which could offer better margins. In this note, we take a look at some of the factors driving the U.S. residential solar space and why we are bullish on SunPower’s prospects in this market.

The economics of rooftop solar are becoming increasingly compelling. Overall residential system prices have declined to about from about $5.22 per watt in Q3 2012 to $4.72 per watt in Q3 2013. ((SEIA)) As of 2012, solar power cost between $0.12 per unit (which is almost at par with the average retail rate in the U.S.) to $0.30 kWh, depending on the region of the United States, [1] and we believe that prices could be still lower this year given the falling systems prices. Also, while the prices of solar power are only expected to fall or remain stable going forward, retail electricity prices could increase. More stringent emission rules for fossil fuel power plants, which account for close to two-thirds of U.S. power generation, could lead to higher generation costs for utility companies.

Financing for solar power systems is also becoming more streamlined. While new homeowners can choose to include the costs of solar systems in their mortgages, many customers have also been opting to lease rather than buy solar systems. According to the SIEA, more than 65% of new residential installations over the past year in California and 85% of new installations in Arizona were third-party owned systems. Leasing makes solar power more accessible to customers since it allows them to stagger their payments and not have to worry about maintenance-related issues.

Many builders are also beginning to take interest in adding solar power systems to their new housing developments. This works well for both buyers as well as builders, since it costs about 20% less to install solar power systems at the time of construction rather than after a home is built. At least 6 out of 10 of the largest U.S. builders now provide an option for solar power panels in their projects. Assuming an average system capacity of around 5 kilowatts (KW), homes can install solar systems at a price below $25,000, which would add just about 7% to the cost of the average new American home. [2]

SunPower’s Strong Product Portfolio, Leasing Program Will Help Drive Growth

The primary requirements of the residential market are high efficiency, good aesthetics and low prices. SunPower’s monocrystalline panels have conversion efficiencies of as much as 21.5% (for its X-series line), which are the highest in the solar industry. SunPower’s panels are also well-reviewed in terms of design. Although SunPower’s panels are more expensive when compared to polycrystalline and thin-film panels, we believe that they will appeal to customers from a total cost of ownership standpoint. Panel costs now account for just about 20% of the total systems price, down from over 50% a few years ago, making price a less significant factor in the panel purchase decision. Additionally, the balance of systems and installations costs could be lower, since SunPower’s panels are more efficient and have a smaller physical footprint. SunPower’s panels also see a lower performance degradation over time when compared to polycrystalline panels, meaning that they can generate more electricity over their lifetime.

SunPower has also been active in the residential leasing market, having signed about 20,000 residential leases to date, with cumulative bookings of over 160 megawatts (MW). Although the company still trails market leader Solar City (NASDAQ:SCTY) in terms of installations, the company’s leasing program could be more profitable due to two reasons. Firstly, the company’s systems are likely to have a better efficiency and performance when compared to Solar City’s systems, which often use panels from Chinese manufacturers such as Trina Solar and Yingli Green Energy. [3] Additionally, SunPower may have an advantage of lower financing costs, given that Total SA, one of the world’s largest oil companies, is its parent company. ((The Motley Fool)) SunPower also recently secured about $220 million in additional financing from Bank of America Merrill Lynch for its residential solar leases.

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